Interview... Donovan: The Pros and Cons
of Warrants for Leasing Space

Interview... Christopher Donovan is a partner in the law firm of McDermott, Will & Emery, a 900-attorney law firm with offices in major U.S. cities. A significant component of his practice is devoted to representing real estate technology companies. Donovan, who is based in Boston, responded to three e-mailed questions on May 1, 2000, regarding the use of warrants for leasing space -- a hot topic in today's overheated real estate markets.

Pike: What are warrants and how can they be used in leasing space?

Donovan: Warrants are a form of equity security that typically entitle the warrant holder to an option to acquire stock (typically common) in the issuer (tenant) company. Technology start-ups frequently allocate a portion of their capitalization for issuance of warrants to banks, advisors, strategic partners, consultants, landlords and others. They are a form of option available to people otherwise not entitled to receive qualified stock options under IRS rules since they are not employees of the tenant. Features include strike price, term, and "cashless exercise" features. Warrants are also sometimes issued to parties who provide revenue to a web site or provide other value to a site.

Pike: What are the pros and cons of warrants from a tenant's perspective?

Donovan: Warrants represent a cashless way for tenants to acquire services, space, and loyalty. VCs, particularly in early stage rounds, are usually more interested in seeing cash spent on brainpower, ideas, and market penetration than bricks and mortar. Warrants are an additional tool to permit the tenant to strike a favorable lease relationship with a landlord, particularly in a tight market. They can result in some dilution to the tenant's overall capitalization, but typically the amount issued is relatively small.

Pike: What are the pros and cons of warrants from an owner's perspective?

Donovan: The recent market gyrations demonstrate most accurately the risks of a landlord underwriting a real estate decision based on the future value of securities. A conflict can also arise between the landlord's role as owner versus its role as warrant holder. Warrants, if limited to a certain percentage in a building (as well as a portfolio) can, however, provide a nice pop to a landlord's rent. In addition, in a tight market (even assuming the tenant defaults and the warrants are worthless), releasing the space is typically not a problem. Landlords need to carefully review and document warrants for dilution, registration rights and a host of other corporate securities issues in order to protect their future value.

--Peter